ALL the time. I would say that about a third of my babies' wardrobe are from baby clothes!
So far, the easiest alterations have been with shirts, sweatshirts, dresses, etc. I have no problems with completely tearing it apart and doing with it what I want!
Here are a couple of pictures I found on my computer. I have a TON of clothes though that are made out of baby clothes. For some reason, I found more for Molly than Max but I have just as many for him as I do for her.
Little Ginger is not really big enough for any clothes (especially baby clothes) so most of her outfits (she only has a couple besides a jacket, dress or two) are made out of socks right now.